Why variable annuities, warts and all, might be right for you

They're not what they used to be, but variable annuities are still a major retirement-planning tool for hundreds of thousands of Americans.

These insurance contracts are reviled by many financial advisors for all the right reasons: They cost a lot, they're hard to understand and they're hard to undo once you've signed a contract. The same criticisms of variable annuity contracts, however, were valid before the financial crisis — and those contracts nonetheless helped many people survive the 50 percent plunge in the stock market.

"I had some clients whose retirements were saved because of [variable annuity] contracts they purchased before the financial crisis," said Marc Ruiz, a financial advisor with Oak Partners and a registered rep with SII Investments.

The terms and prices of variable annuities were much better before the financial crisis, but the rationale for a contract that guarantees an income stream while allowing for some participation in potential growth in the investment markets remains intact, according to Mark Cortazzo, senior partner at Macro Consulting Group.

"We were spoiled rotten by the rich pre-financial crisis contracts," Cortazzo said. "But at the end of the day, if you're a conservative investor, having a variable annuity as a way of transferring risk can still be valuable."

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The value is in the guarantee. If retirees are depending on an investment portfolio for income in retirement, a 2008-like plunge can be devastating. A 5 percent withdrawal rate is suddenly 10 percent. And if the market doesn't recover rapidly or you don't have the stomach to stay invested, the portfolio will not last.

While the value of underlying subaccounts of variable annuities fell through the floor like everything else in the market in 2008, the guaranteed income withdrawal rate (not to be confused with the rate of return of the investment portfolio) did not. Those terms are set when the contract is signed and are based on the highest value of the investment portfolio. In other words, the income stream can go up if the market does, but won't go down even if your account value goes to zero.

"It's about the guarantee," said Oak Partners' Ruiz, adding that one or two clients out of every 10 purchases a variable annuity contract. "The growth potential is constrained by costs and the investment options, but they're a solution for immediate or imminent income needs."

Both Ruiz and Cortazzo say they are using variable annuities sparingly with clients at this point, but for investors who are uncomfortable taking on a lot of market risk, annuities can be a solution. Either way, consumers need to keep some things in mind when contemplating a variable annuity purchase as part of their retirement plan.

Don't go all in with a variable annuity. Variable annuities can be part of a retirement plan, but they shouldn't be the entire plan. Ruiz recommends people not put more than 30 percent to 50 percent of their assets in a contract. "Never put the whole pot in a variable annuity," he said. "If people can't get by on the income [from that allocation], I coach them on reducing their income and spending needs instead."

Cortazzo at Marco Consulting Group also sees a behavioral benefit to establishing a guaranteed income stream. "An annuity with an income guarantee provides a safety net and allows people to be more growth-oriented in the rest of their portfolio," he said.

Keep it simple. A variable annuity is a contract with an insurance company and it can come with a lot of bells and whistles. Those bells and whistles cost money, so it pays to keep it simple.

"The more you load the contract up with features, the bigger the drag on the portfolio," said Cortazzo.

For his part, Ruiz at Oak Partners favors contracts that focus on a simple income guarantee (a living benefit) rather than market hedging or structured product annuities with loss buffers and complicated performance triggers. "Some people like them, but we look at variable annuities as a simple and specific core income solution," he said.

In some cases, a death benefit may make sense, particularly if there is a large difference in age between spouses. But they can cost a lot, and the same protection may be available with a lower-cost term life insurance policy.

Understand the guarantee. Ruiz said that one of the biggest sources of confusion about variable annuities for consumers is the insurance guarantee. Income guarantees do not guarantee a return on your investment. Instead, they set the rate at which you can withdraw funds from the account.

The rate is applied to your initial investment or to a higher portfolio value if the market goes up. It does not guarantee a return on the underlying investments in your annuity sub-accounts. "Consumers confuse the income guarantee with a guaranteed return and they overpay because of it," said Ruiz.

Shop around. If ever a market deserved a "buyer beware" warning, it is variable annuities. The contracts vary widely by carrier and can be famously convoluted and difficult to understand. The key things to consider, said Cortazzo at Macro Consulting Group, are whether the investment options have flexibility, do the guarantees cover the things you need to protect, who do they cover (i.e., annuitant, spouse, beneficiaries) and how much does it cost.

There are websites that allow you to compare annuity terms and prices and financial advisors will assess contracts for a fee. "We look at these contracts on a case by case basis," said Cortazzo. "The products vary depending on whether a company is trying to grow that part of their business."

— By Andrew Osterland, special to CNBC.com